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June 25, 2014

BofA-Merrill Sees Weak Economy, Strong Stocks

Analysts compare poor growth the 'ugly elephant in the room' but point to sectors that could see upside

“It’s a healthy U.S. economy, but the global backdrop is not supporting it,” a Merrill economist says.

After hearing Wednesday’s news that the U.S. economy contracted 2.9% in the first quarter, Bank of America-Merrill Lynch experts shared their thoughts on what’s holding growth back and what’s driving equities forward.

“There’s nothing great happening in the economy,” said Bank of America-Merrill Lynch global economist Ethan Harris on a call with the press, “though we are getting rid of the fiscal headwind.”

Harris says the -2.9% growth in Q1’14 is the “ugly elephant in the room. We can’t figure it out. It’s like watching [Uruguayan striker Luis] Suarez bite someone on the soccer field!”

Analysts with BofA-Merrill “put low weight on the message being sent by the latest GDP report,” he adds. “In many ways, it’s a healthy U.S. economy, but the global backdrop is not supporting it.”

Earlier this week, BofA-Merrill issued a three year outlook for productivity and other measures. The group forecasts U.S. GDP growth of 2.0% in 2014, 3.2% in 2015 and 3.4% in 2016.

Equities Outlook

The group is more upbeat about the stock market and sees the S&P 500 hitting 2,000 this year. The index traded at 1,957 on Wednesday.

“The second half of the year could be interesting in terms of volatility related to a change in interest rates and the lead-up to such a shift,” said Savita Subramanian, head of U.S. equity strategy for the BofA-Merrill research team.

In terms of concerns that the market is complacent due to low volatility, Subramanian points to sell-side indicators -- Wall Street’s recommendations – that she and other analysts follow. As of May 31, it was at a 51%-equity portfolio allocation.

“This is a very reliable contrarian indicator,” she explained, noting that the 15-year average is 60%. “In other words, there is more upside than downside risk.”

Far from being overly euphoric, “We’re still climbing a wall of worry. The [51% figure] is surprisingly low, given the fact that other assets – like bonds and cash – are not attractive,” Subramanian said.

As for sector weights, BofA-Merrill is overweight the energy, technology and industrial groups with an emphasis on large-cap holdings. “These are globally exposed, GDP-sensitive sectors,” she explained.

The research group is underweight on consumer discretionary, utilities and telecommunications.

“There’s a real opportunity to play the increasing-interest-rate trade,” the analyst added. She pointed to sectors that are relatively cheap at the moment: technology, autos, consumer finance and electrical equipment, as well as communications equipment.

“If interest rates don’t rise, then these aren’t the plays,” Subramanian said, “and it’s better to look at utilities and tobacco, for instance.”

Other Issues

Fixed-income specialist David Woo described the role of climate change and changing weather patterns on the global economy.

“Why are we holding [interest] rates hostage?" Woo asked. "It’s the weather, and we’re still talking about it – and it’s nearly July!”

This past winter was the third worst in the United States for the past 100 years, after 2009 and 1977, he says. It was also one of the longest on record. “I was wearing a coat in May,” he joked.

Meanwhile in Europe, it was the warmest winter of the past 50 years. “And they’ll have good rates in some countries this year,” Woo explained.

“The weather and climate change are key” to the global economy’s story, he added, “and will be going forward.”

As for commodities, Bank of America-Merrill Lynch points to a “massive rally” in the long-dated prices of oil, which are about 5 years out, according to researcher Francisco Blanch.

Blanch also says that aluminum prices may have “bottomed.” “If there’s a [GDP growth spike], we could see a meaningful pickup in aluminum prices,” he noted.

He also sees brighter days ahead for natural-gas prices. “Over the next five years, there could be 18% pent-up demand growth,” the expert said. “The bottom line is that it’s a strong picture, and prices could go higher.”

High-grade fixed-income specialist Hans Mikkelson’s chief prediction is that there could be a 50% jump this year in volatility for this asset class. “There’s limited upside and higher risks,” he said on the press call.

Overall, though growth had been below 2% in some recent years, “It shouldn’t stay there,” he said, “as corporations move to increase capital expenditures and capacity.”

The long-term U.S. growth rate is likely to be about 2.2%, below the 3.3% level seen during the tech boom.

U.S. growth is unlikely “to be consumer driven,” Harris says. “Consumers have learned the hard way that they must save. They just can’t assume that there will be increases in housing prices and stocks.”

With the U.S. consumer unlikely to be the growth engine of the global economy, the burden shifts to emerging markets. “It’s all about demographics,” the economist stressed, “and it’s becoming an emerging-markets world.”

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